Policy Responses to Balance-of-Payments Crises: The Role of Elections

Abstract

Governments have a number of policy tools that can be used to address pressure on the balance of payments. When market pressure leads to an unsustainable decline in the relative value of the domestic currency, authorities can: (1) sell reserves, (2) raise interest rates, (3) impose capital controls, (4) apply trade restrictions, or (5) depreciate the currency. While researchers typically analyze these policies in isolation from one another, we treat them as a menu of options available to election-minded politicians. We construct a new dataset that documents patterns in the use of these five policy responses to payments difficulties for a large sample of countries since the early 1970s. We argue that governments try to minimize political costs by adopting less transparent policies first and only moving to more visible policies if necessary, delaying the most visible and politically-costly policies until after elections. These claims are consistent with our findings: governments are more likely to draw down reserves and impose capital controls before other options. If these policies do not succeed, they tend to raise interest rates. If further action is needed, they delay devaluations and trade protection until after elections.

Keywords: currency crises, balance of payments, electoral politics

JEL Classification: F13, F32, F36, F40, F41, F42